Confirmation Bias – Understanding Behavioral Biases in Finance

Confirmation bias is the inclination to seek or make sense of news or facts in a way that validates one’s preconceptions. So, during the decision making process for psychologist they will refer to information that supports their decision more favorably. They will rarely give the obvious negative much consideration and since our beliefs and postulations are definitely prejudiced so the tendency to give more attention and weight to data that support our beliefs than we do to contrary data will subtly but gradually have a harmful effect.

An illustration of Confirmation Bias

A very real manifestation of this tendency can be observed in the virtual world. For instance, investors are increasingly turning to message boards or virtual communities to search, clarify, and exchange information before making investment decisions. The volume of discussion on such portals is so intense that it has become possible to sense stock sentiments from here. These message boards have been shown to provide more accurate and timely information than forecasts by analysts.

The reason so many investors even turn to these online communities is to gain an unbiased evaluation of the market conditions, a third-party opinion on something they might not have comprehensive information about, and the 360 degree view of the situation that can help in formulating a successful investment strategy. What in turn happens is that psychological biases, especially in such uncertain and noisy environments, affect the processing of information through these portals leading to short-sighted or impaired decision making.

It can be debated that investment-related message boards and communities do not necessarily benefit potential investors by helping them make unbiased and informed decisions, primarily because investors search for specific information on these portals that align with what they already believe.… Read the rest

International Equity Investments – Euro Equities

International equities or the Euro equities do not represent debt, nor do they represent foreign direct investment. They are comparatively a new financial instruments representing foreign portfolio equity investment. In this case, the investor gets the dividend and not the interest as in case of debt instruments. On the other hand, it does not have the same pattern of voting right that it does have in the case of foreign direct investment. In fact, international equities are a compromise between the debt and the foreign direct investment. They are the instruments that are presently on the preference list of the investors as well as the issuers.

Benefits to Issuer/ Investor

The issuers issue international equities under certain conditions and with certain objectives. First, when the domestic capital market is already flooded with its shares, the issuing company does not like toad further stress to the domestic stock of shares since such additions will cause a fall in the share prices. In order to maintain the share prices, the company issues international equities. Secondly, the presence of restriction on the issue of shares in the domestic market facilitates the issue of Euro equities. Thirdly the co company issues international equities also for the sake of gaining international recognition among the public. Fourthly, international equities bring in foreign exchange which is vital for a firm in a developing country. Fifthly, international capital is available at lower cost though the Euro equities. Sixthly, funds raised through such an instrument do not add to the foreign exchange exposure.… Read the rest

Meaning of Bonus Shares

The term bonus issue also called as stock dividend means an extra dividend paid to shareholders in a company from additional profits. When large fund gets accumulated out of profits of a company much beyond its expectations and needs, the company’s directors may decide to share out a part of it among the existent shareholders of company in the form of bonus. Bonus can be paid in two forms either in cash or in form of shares. The company pays cash bonus when it gains large amount of profits as well as cash to pay dividend. But many a times, it happens that a company is not in a position to pay bonus in cash though it has enough amounts of profits because of poor cash position or because of its unfavorable effects on the working capital of the company. In such a situation, the company pays a bonus to its shareholders in the form of shares; a free share thus issued is known as a bonus share.

A bonus share is a free share of stock given to current/existing shareholders in a company, based upon the number of shares that the shareholder already owns at the time of announcement of the bonus. The important point here is, that the issue of bonus shares only increases the total number of shares issued and owned, but it does affect the value of the company at all.  In the wake of a bonus issue, the shareholders proportionate ownership remains unchanged. The book value per share, the Earnings Per Share (EPS) and the market price per share will decrease, but the number of shares (stock outstanding) will increase.… Read the rest

Advantages of Rolling Settlement

Rolling settlement system replaced the badla system from July 2, 2001. On July 2, 2001, 215 scrips were brought under the riling systems, bringing the total to 414 scrips. By January 2, 2002 all scrips were brought under compulsory rolling mode. Internationally most developed countries follow a T+3 cycle and are aiming to move to a T+1 cycle (next day settlement) or a T+0 cycle where trades are settled on the day they are executed (same evening settlement). This is system of T+0 is prevalent in Switzerland and volumes are phenomenal when compared to the T+3 system. Indian stock markets moved to the T+3 system from April 2002, in line with the recommendations of the “Group of Thirty” which suggested it as minimum international standard.

The rolling settlement has many advantages. One, it reduces speculation and arbitrage in scrips as settlement occurs on a daily basis. Thus, there would be increase in delivery-based transactions reducing the speculation currently existing by way of carry forward of position in various scrips. Apart from this, shifting position from one stock exchange to another will reduce which, in turn will eliminate arbitrage opportunities in scrips. Two, it reduces pricing glitches and manipulation and explores a better price discovery process. With the rolling settlement in place, all open positions at the end of each day would come up for delivery thereby improving the quality of cash market transactions. Thus, price formation process on daily basis would be improved thereby resulting in improved price discovery process. Three, it reduces end of settlement period pressure as shares are delivered and cash is paid everyday instead of a week.… Read the rest

Liquid Mutual Fund Schemes

The objective of liquid mutual fund schemes is to invest in short-term money market instruments of good credit quality. The fund predominantly invests in money market instruments and provides investors the returns that are available on these instruments. The investment portfolio is very liquid, and enables investors to hold their investments for very short horizons of a day or more. The liquid funds are normally open-ended. It provides with the following options/schemes, which are sub-products within the liquid fund.

  • Overnight Option (Growth): This option is meant to be used by investors with very short-term investment horizon and is fully invested in the call money market.
  • Overnight Option (Dividend): This option is meant for investors who have short-term funds to deploy but would like to earn some income on such deployment. The portfolio in this option is invested in short-term floating rate instruments, call markets and in repos. The average maturity of this portfolio is about 8 days. Dividends are declared daily under this option.
  • Liquid-fund Option (Growth): This option is meant for investors with short-term funds, but of a slightly longer duration. The average maturity of the portfolio is about 15 days and about 45% of the portfolio is deployed in short-term debt instruments with a fixed rate of return. The balance is invested in short-term floating rate instruments and call markets.
  • Liquid-fund Option (Dividend): This option is meant for investors with short-term funds, investment horizon slightly longer, but with the need to earn dividend income. The average maturity of the portfolio is 25 days and about 55% of the portfolio is invested in fixed rate short-term products, with the balance in call money markets and short-term floaters.
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Balanced Mutual Funds

Mutual funds that invest both in debt and equity markets are called balanced mutual funds or simply balanced fund. A typical balanced fund would be almost equally invested in both the markets. The variations are equity funds that invest predominantly in equity (about 70%) and keep a smaller part of their portfolios in debt securities. These funds seek to enhance the income potential of their equity component, by bringing in debt. Similarly, there are predominantly debt funds (over 70% in debt securities) which invest in equity, to provide some growth potential to their funds. A balanced fund also tends to provide investors exposure to both equity and debt markets in one product. Therefore, the benefits of investment diversification get further enhanced as equity and debt markets have different risk and return profiles.… Read the rest